Benefits of Trade and Comparative Advantage

Supplementary resources by topic. Benefits of Trade and Comparative Advantage is one of 51 key economics concepts identified by the National Council on Economic Education (NCEE) for high school classes.

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Definitions and Basics

A person has a comparative advantage at producing something if he can produce it at lower cost than anyone else..

Having a comparative advantage is not the same as being the best at something. In fact, someone can be completely unskilled at doing something, yet still have a comparative advantage at doing it! How can that happen?....

We all have a good intuitive understanding of the power of trade. At the simplest level, if you have something I want and if I have something you want, and we trade we each other, we're both better off.

So if I can knit and you can't, and if you can grow corn and I can't, it obviously makes sense for me to swap one of my sweaters for some of your corn. You and I might argue about the "price"—how many ears of corn one of my gorgeous sweaters is worth—but once the deal is done, you're warmer and I'm on my way to being less hungry.

Trade seems simple.

Almost two hundred years ago, David Ricardo discovered something not so simple about trade that came to be called comparative advantage. Here is a story that will let us explore the mysteries of trade together.

Absolute Versus Comparative Advantage: The most straightforward case for free trade is that countries have different absolute advantages in producing goods. For example, because of differences in soil and climate, the United States is better at producing wheat than Brazil, and Brazil is better at producing coffee than the United States. Obviously both countries are better off when Americans produce wheat and exchange a portion of it for some of the coffee that Brazilians produce.

But does this mean that a country with an absolute advantage in the production of a good should always produce that good rather than import it? No, as the English economist David Ricardo first explained in the early 1800s. A country can have an absolute advantage in the production of a good without having a comparative advantage. Comparative advantage is what determines whether it pays to produce a good or import it....

In the News and Examples

Mike Munger of Duke University talks with EconTalk host Russ Roberts about the often-vilified middlemansomeone who buys cheap, sells dear and does nothing to improve the product. Munger explains the economic function of arbitrage using a classic article about how prices emerged in a POW camp during World War II. Munger then applies the analysis to the financial crisis.

"Then I hope your honour will set us right," replied Bob.—"Why," said the landlord, "I maintain that, when two countries trade freely with each other, they are both gainers."...

"This requires some explanation," said the landlord, "which I will try to give you. Foreigners send over to us such goods as they can make or produce cheaper and better than we can; therefore, when we buy those goods, we get them cheaper or better than we could have made them ourselves."... [par. 8.20]

A Little History: Primary Sources and References

For over 200 years, economists have touted an alternative approach in which specialization leads to wealth and self-sufficiency leads to poverty. In Book IV, Chapter 3, paragraph 31 of An Inquiry into the Nature and Causes of the Wealth of Nations (1789; 1st edition: 1776), Adam Smith showed how both parties can benefit from trade, but it was David Ricardo who is credited with what is commonly called "comparative advantage," the idea that both parties can benefit from trade even if one of them is better at producing everything than the other....

Chapter 7, by David Ricardo, in On the Principles of Political Economy and Taxationon Econlib

To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth. [par. 7.16 (See also pars. 7.13-7.15)]

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